Investing In The iPhone 5 Via Apple's Suppliers: 2 Names To Consider

The iPhone has generated billions in profits for Apple (NASDAQ:AAPL) since it was introduced, and has helped Apple become the world's largest company by market capitalization. And with the iPhone 5 set to be released Sept. 12, Apple's position in the smartphone market seems secure. However, investing in Apple is not the only way to profit from the release of the new iPhone. Apple's suppliers have also been rewarded by their relationships with the company, and with the iPhone 5 seen by many analysts as the largest consumer electronics launch in history, Apple's suppliers are set to do thrive in the next several months. We want to highlight three of them here that may be overlooked by investors.

When one thinks of Apple's suppliers, several names immediately come to mind: Qualcomm (NASDAQ:QCOM), Broadcom (NASDAQ:BRCM), and Cirrus Logic (NASDAQ:CRUS). And while we believe that all three of these companies are worthwhile investments, they are not the only companies that can thrive as part of the Apple ecosystem. We would like to highlight two companies that also have the potential of thriving as part of this world: OmniVision Technologies (NASDAQ:OVTI) and Avago (NASDAQ:AVGO).

OmniVision and Apple: A Dramatic Relationship

The largest Apple suppliers, such as Qualcomm and Broadcom, have very little to worry about when it comes to their relationship with Apple. This is due in large part to the fact that their components are essential in constructing Apple's "iDevices." There is little chance that either Qualcomm or Broadcom will be ousted from their positions in Apple's device lineup. OmniVision, however, does not have such certainty. OmniVision produces camera and imaging sensors for several smartphone lines, including the iPhone. And while OmniVision has benefited at times from its dealings with Apple, over the past five years its investors have not.

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It is much easier for Apple to replace OmniVision's technology than it is to replace technology from Qualcomm or Broadcom. And this is reflected in OmniVision's share price, which rises and falls along with investor sentiment toward the company's relationship with Apple. In 2011, shares plunged as the company's place in the iPhone 4S was claimed by Sony (NYSE:SNE). However, OmniVision's latest quarterly results offer proof that the company has put itself back into Apple's good graces, and we believe that the next several quarters should be a time of prosperity for OmniVision.

On Aug. 30, OmniVision reported its Q1 2013 (fiscal) results. The company posted EPS of 21 cents per share on revenues of $258.1 million, missing EPS estimates by a penny and beating on the top line by $15 million. But Q1 results were not the biggest focal point of the company's earnings call. OmniVision's Q2 guidance was what mattered. The company guided for revenues of $355 million to $390 million and EPS of 21-37 cents per share, compared to consensus analyst estimates of 33 cents in EPS and revenues of $268.6 million. OmniVision smashed revenue forecasts while also missing EPS estimates (at the midpoint of guidance). This implies that the company has won huge new contracts, which are pressuring margins in the short term. OmniVision forecasts gross margins of around 17% for the next quarter, its lowest ever. During the call, CFO Anson Chan stated that demand for the company's new BSI-2 sensors is so strong that its manufacturing partners are being forced to rush installation of new manufacturing equipment to meet demand. This is pressuring margins at the moment, but this model does indeed have leverage. During the call, OmniVision stated that it expects to mitigate the supply/demand mismatch for its new sensors by the end of the year, noting that demand continues to outweigh supply at the present moment.

Apple is known to drive a hard bargain with its suppliers, but that is the price suppliers must pay for doing business with the company. However, we think the iPhone 5 will be a winner for OmniVision, and management's commentary backs up this assertion. While the company never mentioned the iPhone by name during its call, it is clear to everyone that the iPhone is the driver of both OmniVision's sales growth and its lower margins. Needham (which has a buy rating and $21 price target on OmniVision) notes that, at a minimum, OmniVision is likely to be supplying the front-facing 1.3-megapixel camera on the iPhone 5, given the company's upbeat commentary about that subset of the market. The firm also believes that here is a strong likelihood that OmniVision has recaptured the 8-megapixel back camera.

While fiscal 2013 is set to be a transition year for OmniVision, fiscal 2014 will be a record year for the company, and a buying opportunity may be at hand. As of this writing, OmniVision trades for just 13.71 times fiscal 2013 EPS and 10.07 times fiscal 2014 EPS.

Those ratios become even lower when the company's $314.309 million in net cash and investments are excluded. Based on those figures, and OmniVision's outstanding shares, the company has net cash and investments of $5.94 per share, which is over 36% of its current market capitalization. OmniVision's shares have been battered by worries about is relationship with Apple. However, recent indicators suggest that OmniVision is once again part of the Apple ecosystem, and we believe that in the quarters to come, the OmniVision's share price will rise to reflect these changing dynamics.

Avago: Profiting Under the Radar

When investors think of the technology companies that benefit the most from dealing with Apple, the same batch of names usually comes up. Qualcomm. Broadcom. ARM Holdings (NASDAQ:ARMH). Cirrus Logic. But there is one name that is rarely mentioned, and it is one that we would like to highlight. That company is Avago Technologies. Avago was founded in the 1960s as Hewlett-Packard's (NYSE:HPQ) component division, and was spun off alongside Agilent Technologies (NYSE:A) in 1999. In 2005, Avago was bought by KKR and Silver Lake, and the company began trading on the Nasdaq in 2009. Avago is a relatively new Apple supplier, having made its first meaningful impact in the iPhone 4S, where it supplied the phone's power amplifier module.

While Avago has dramatically outperformed the S&P 500 since it began trading in 2009 (up 114% vs. 43% for the S&P 500), shares have underperformed over the past year, rising by just 13%, compared to an advance of nearly 25% for the S&P 500.

However, we feel that with the launch of iPhone 5, Avago can break out of its recent range.

Avago reported its Q3 2012 (fiscal) results on Aug. 16. The company posted EPS of 72 cents on revenues of $606 million, both of which beat estimates (63 cents in EPS on revenues of $600 million). On the surface, Avago's guidance was not that impressive. The company guided for sequential revenue growth of just 0%-3% for Q4 2012, hardly the kind of growth that investors would expect to see from an Apple supplier around the launch of a new iPhone. However, Avago's revenue growth is blurred by several changes to its business model. The company is transitioning to a licensing and royalty model for its computing and consumer peripherals division, which will reduce quarterly revenues by about $30 million. Avago's wireless division, however, is set to post solid growth of between 20% and 30% in Q4, driven by growth in iPhone shipments.

Avago's exposure to the iPhone is not the only reason to buy shares, however. As Sterne, Agee & Leach notes in its latest research update on Avago (the firm has a buy rating and $44 price target), the company's solid free cash flow provides a "third leg" to the bullish thesis for the stock, one that is underappreciated by the market (rising iPhone sales will also lead to a boost free cash flow). An analysis by Sterne, Agee & Leach shows that Avago can generate $2 of free cash flow per share, and "a net-cash-flow per share post buybacks-dividends of a still incremental $1-$2 per share per year." Avago has $973 million in cash and investments on its balance sheet and just $3 million of capital lease obligations. That is equivalent to $3.88 in net cash per share, or 11.03% of Avago's market capitalization. As was the case with OmniVision, this will be a transition year for Avago as the company makes changes to its business model. Earnings per share are expected to fall by 0.78% in 2012, and grow by 11.86% in 2013.

As of this writing, Avago trades at 13.91 times estimated 2012 earnings, and 12.43 times estimated 2013 earnings. We are bullish on Avago not only because of its financial strength, but because its relationship with Apple is relatively new. Even though shares have more than doubled since the company began trading, there is likely a good deal of upside remaining. Adding in a strong balance sheet and a growing dividend (the stock currently yields 1.82%, and the quarterly payout of 16 cents has more than doubled from 7 cents in 2010) makes shares of Avago even more attractive at current levels.

Conclusions

Investors need to look beyond the usual suspects when it comes to investing in the Apple ecosystem. While companies such as Qualcomm and Broadcom are solid investments (we own shares of Qualcomm), they are far from the only way to profit from Apple's iDevices. Companies such as OmniVision and Avago are also poised to thrive thanks to Apple, and we believe that investors should take a close look at both companies.

In the next several days, we will be examining our exposure to the Apple ecosystem and may buy shares of these companies. In our view, both companies have their best days ahead of them, and with seven days left until Apple launches the iPhone 5, the time to consider adding to or initiating positions in OmniVision and Avago is at hand.

Disclosure: I am long AAPL, QCOM. We may initiate a position in either OVTI or AVGO (or both) within the next several trading days. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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